The computation of VaR for a fixed income portfolio differs in important ways from that of an equity portfolio. First, unlike in the case of an equity portfolio where observed prices can be directly used for the computation of VaR, the price of each fixed income instrument in a portfolio is an outcome of many security-specific attributes, in addition to the fundamental factor, the underlying term structure. This rules out the use of prices directly for the computation of VaR if the objective is to measure the interest rate risk that the portfolio is subject to . Use of a zero coupon yield curve (ZCYC) is central to the exercise, as yield-to-maturity (YTM) based approaches are also subject to the same problem as with use of observed prices. Movements of the ZCYC, inasmuch as they depict the changes in the interest rate structure, are reflective of changes in the value of the portfolio occurring on account of interest rate changes alone.

Estimation of VaR for a portfolio of fixed income securities is complicated by two reasons: one, the changes in market values of the securities are non-linearly related to changes in spot interest rates leading to difficulties in making simple assumptions about the distribution of the portfolio returns. A related point is that since one needs to know the entire term structure of interest rates to value a fixed income security (up to the relevant maturity), to study the VaR of the security we need to model the distribution of a great number of interest rates. The popular practice of cash-flow mapping considers a selected set of interest rates and maps the cash flow timings to that of the tenor of the selected interest rates through linear interpolations. Underling in this strategy is interest rates are distributed as normal or conditional normal, an assumption not typically supported by the data. In addition, the cash-flow interpolations may also lead to significant approximation errors. A better strategy would be to generate ‘returns’ on (a portfolio of) fixed income instruments at the first stage by valuing the said portfolio on observed yield curves, and estimate the VaR directly from the returns on the bond portfolio. A major advantage of this approach is that it does not require an assumption about the interest rates. Since the VaR is estimated based on bond portfolio returns, this approach has the disadvantage of being portfolio specific thereby necessitating the model parametrization, and estimation to be done for each portfolio separately. The NSE-VaR system follows the latter approach of generating returns via historical simulation and fitting a model of VaR to the return series.